Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Thursday, February 11, 2016

Romancing The Income

Let’s discuss
Blagaich, an early 2016 decision from the Tax Court. This is a
procedural decision within a larger case of whether cash and property transfers
represent income.

Blagaich was
the girlfriend and in 2010 was 54 years old.

Burns was
the boyfriend and in 2010 was 72 years old.

Their
romance lasted from November 2009 until March 2011.

It appears
that Burns was fairly well heeled, as he wired her $200,000, bought her a
Corvette and wrote her several checks. These added up to $343,819.

He was sweet
on her, and she on him. Neither wanted to marry, but Burns wanted some level of
commitment. What to do …?

On November
29, 2010 they decided to enter into a written agreement. This would formalize
their “respect, appreciation and affection for each other.” They would “respect
each other and … continue to spend time with each other consistent with their
past practice.” Both would “be faithful to each other and … refrain from
engaging in intimate or other romantic relations with any other individual.”

The
agreement required Burns to immediately pay Blagaich $400,000, because nothing
says love like a check you can immediately take to the bank.

Surprisingly,
the relationship went downhill soon after entering into the agreement.

On March 10,
2011 Blagaich moved out of Burn’s house.

The next day
Burns sent her a notice of termination of the agreement.

That same
month Burns also sued her for nullification of the agreement, as she had been
involved with another man throughout the entire relationship. He wanted his
Corvette, his diamond ring - all of it - returned.

Somewhere in
here Burns must have met with his accountant, as he/she sent Blagaich a Form
1099-MISC for $743,819.

She did not
report this amount as income. The IRS of course wanted to know why.

The IRS learned
that she was being sued, so they decided to hold up until the Circuit Court heard
the case.

The Circuit Court
decided that:

·The
Corvette, ring and cash totaling $343,819 were gifts from him to her.

·The
$400,000 was different. She was paid that under a contract. Flubbing the
contract, she now had to pay it back.

Burns had
passed away by this time, but his estate sent Blagaich a revised Form 1099-MISC
for $400,000.

With the Circuit
Court case decided, the IRS moved in. They increased her income by $743,819,
assessed taxes and a crate-load of penalties. She strongly disagreed, and the
two are presently in Tax Court. Blagaich moved for summary adjudication,
meaning she wanted the Tax Court to decide her way without going through a full
trial.

QUESTION: Do you think she has
income and, if so, in what amount?

Let’s begin
with the $400,000.

The Circuit Court
had decided that $400,000 was not a gift. It was paid pursuant to a contract
for the performance of services, and the performance of services usually means income.
Additionally, since the payment was set by contract and she violated the contract
terms, she had to repay the $400,000.

She argued
that she could not have income when she had to pay it back. In legal-speak,
this is called “rescission.”

In the tax
arena, rescission runs head-on into the “claim of right” doctrine. A claim of
right means that you have income when you receive an increase in wealth without
a corresponding obligation to repay or a restriction on your being able to
spend. If it turns out later that you in fact have to repay, then tax law will
allow you a deduction – but at that later date.

Within the
claim of right doctrine there is a narrow exception IF you pay the money back
by the end of the same year or enter into a binding contract by the end of the
same year to repay. In that case you are allowed to exclude the income
altogether.

Blagaich did
not do this. She clearly did not pay the $400,000 back in the same year. She
also did not enter in an agreement in 2010 to pay it back. In fact, she had no
intention to pay it back until the Circuit Court told her to.

She did not
meet that small exception to the claim-of-right doctrine. She had income. She will
also have a deduction upon repayment.

OBSERVATION: This is a problem if one’s future income goes
down. Say that she returns to a $40,000/year job. Sure, she can deduct
$400,000, but she can only offset $40,000 of income and the taxes thereon. The
balance is wasted. Practitioners sometimes see this result with athletes who
retire, leaving their sport (and its outsized paychecks) behind. It may never
be possible to get back all the taxes one paid in the earlier year.

Let’s go to
the $343,819.

She argued
that the Circuit Court already decided that the $343,819 was a gift. To go
through this again is to relitigate – that is, a double jeopardy to her. In
legal-speak this is called “collateral estoppel.”

The Court
clarified that collateral estoppel precludes the same parties from relitigating
issues previously decided in a court of competent jurisdiction.

It also pointed
out that the IRS was not party to the Circuit Court case. The IRS is not
relitigating. The IRS never litigated in the first place.

She argued
that the IRS knew of the case, requested and received updates, pleadings and
discovery documents. The IRS even held up the tax examination until the Circuit
Court case was decided.

But that
does not mean that the IRS was party to the case. The IRS was an observer, not
a litigant. Collateral estoppel applies to the litigants. That said, collateral
estoppel did not apply to the IRS.

Blagaich
lost her request for summary, meaning that the case will now be heard by the
Tax Court.

What does
this tax guy think?

She has very
much lost the argument on the $400,000. Most likely she will have to pay tax
for 2010 and then take a deduction later when she repays the money. The problem
– as we pointed out – is that unless she has at least $400,000 in income for
that later year, she will never get back as much tax as she is going to pay for
2010. It is a flaw in the tax law, but that flaw has been there a long time.

On the other
hand, she has a very good argument with the $343,819. The Court was correct
that a technical issue disallowed it from granting summary. That does not however
mean that the technical issue will carry the day in full trial. That Circuit
Court decision will carry a great deal of evidentiary weight.

We will know
the final answer when Blagaich v Commissioner goes to full trial.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.